In the last few days, we have seen the credit default swaps (CDS) spreads widening in many eurozone countries. Even the CDS spreads on US banks have widened significantly after the US rating downgrade.

In this article, let’s take a look at what this means.

Credit Default Swaps are a type of credit derivatives in which the credit exposure of a loan or a fixed income security is transferred to the swap counterparty for a fees. The buyer of the CDS is protected from the risk of the loan defaulting.

The fees or the “spread” is the annual amount that the protection buyer must pay to the protection seller for the entire duration of the CDS contract. The spread is calculated as a % of the nominal amount.

Let’s take an example to understand this.

Assume that an investor buys a CDS from ABC bank, where the reference entity is RR Corp (The actual borrower). For this CDS, investor (the protection buyer) will pay a spread to ABC bank (the protection seller). If the RR Corp. defaults on the loan during the CDS period, then the ABC bank will pay a lump sum as compensation to the investor. No payment will be made if the RR Corp. doesn’t default or if the CDS expires.

If the CDS spread for RR Corp is 25 bps, and the investor is buying protection for $1 million, then the spread paid will be $2,500 per year.

While comparing two CDS transactions, all other factors being same, the one with a higher CDS spread is considered to be like to default by the market, because a higher fees is being charged to protect against the default.

Money managers consider the credit ratings and the CDS spreads of the reference entities as two important factors while assessing the likelihood of the credit event.

The credit spreads represent the pure credit risk and are linked with the credit ratings issued by the ratings agencies. When an entity is downgraded, it results in a CDS spread widening, because the perceived credit risk of the entity has increased. Even though CDS spreads should represent the pure credit risk of the firm, other factors such as worsening macroeconomic conditions also result in a credit spread widening. The five common variables that affect CDS spread include the equity market’s implied volatility, industry, leverage of the reference entity, the risk-free rate, and liquidity of the CDS contract.

The changes in CDS spreads also affect the stock prices. When CDS spreads widen, it is a bearish signal, and the stock prices of the firm typically fall.